Threading the Fiscal Needle

PALO ALTO – Elections often turn on the state of the economy, especially in hard times. When growth and jobs are down, voters throw out incumbents – whether Spanish leftists, French rightists, or Dutch centrists. The United States is no exception. Three years into the Great Depression, Herbert Hoover was trounced by Franklin Delano Roosevelt. In 1980, following a severe bout of stagflation, Ronald Reagan routed Jimmy Carter.

At the same time, economic performance depends to a considerable extent on economic policy. The Great Depression was intensified by poor monetary policy, tax hikes, and protectionist trade policies. Likewise, loose US monetary policy in the middle of the last decade helped to set the stage for the Great Recession by contributing significantly to an explosion of leverage and fueling the housing bubble that burst in 2007-2008.

The outcome of two related policy battles will be key to the economic and political outlook in both the US and Europe. The first is between “austerity” and “growth” – that is, short-term deficit reduction and additional fiscal stimulus. Many on the left, on both sides of the Atlantic, argue that more, not less, government spending is required to lift their economies out of recession. Those on the right believe that governments’ top priority should be fiscal consolidation.

In Europe, large deficits and exploding debt-to-GDP ratios have alarmed creditors and provoked political tension. In particular, Germany demands more fiscal belt-tightening from heavily indebted Southern European countries, whose unions (and voters) are rejecting further austerity. While the US has thus far avoided the bond market’s wrath, American political leaders confront the same problem of debt and fiscal sustainability.  

The second battle involves long-run structural issues: slowing the growth of government spending, reforming taxes, and increasing labor-market flexibility. In Europe, for example, raising the retirement age for public pensions and shrinking government employment would curtail welfare-state excesses.

In the US, Reagan’s victory in 1980 appeared to signal that America would stop well short of the European social-welfare model. But President Barack Obama and his congressional allies have rejected the consensus that government should be only a last resort for those in need, in favor of greater dependence, for both individuals and firms, on entitlement programs and other public spending, targeted tax breaks, regulations, and loans.

Separating the budget’s effects on the economy from those of the economy on the budget is tricky. There are several cases – Ireland and Denmark in the 1980’s, for example – in which fiscal consolidation helped to expand the economy in the short run, as lower interest and exchange rates boosted confidence enough to stimulate demand.

Of course, if many of the world’s economies attempt to consolidate simultaneously, with interest rates already low and some of the largest in a monetary union, such a favorable result is less likely. But the evidence on whether additional deficit-financed spending would quickly revive economic growth is mixed.

In a recent survey, “Fiscal Policy for Economic Growth,” I concluded that short-run multipliers – the total change in economic activity resulting from higher government spending – could theoretically be as large as two when the central bank has reduced its target interest rate to zero. In other words, one dollar spent by the government could boost GDP by two dollars in the very short run.

The catch is that the multiplier turns negative by year two: extra government spending contracts, rather than expands, medium-term and long-term economic growth. Moreover, the short-run effect is lower in highly indebted countries, and can even be negative during economic expansions if households and firms, expecting higher taxes to pay for future spending, save, rather than spend, the cash.

Postponing fiscal consolidation risks aborting it, but consolidating too aggressively risks temporarily hindering growth. But those now demanding further deficit-financed stimulus must confront considerable evidence that an overhang of public debt impedes growth for a long time. In a recent paper following up on their book This Time is Different, the economists Carmen Reinhart and Kenneth Rogoff concluded that debt/GDP ratios above 90% tend to be associated with an annual growth slowdown of a full percentage point for 23 years. Thus, a debt overhang cumulatively costs more in lost income than a deep recession does.

Wise policy simultaneously considers short-, medium-, and long-term effects. Both Europe and the US badly need long-run reforms, for example, of public pensions and health care. Europe requires structural labor-market reform and must resolve its sovereign-debt overhang, banking crises, and the euro’s future. America must reform its tax code to raise revenue across a wider array of people and economic activity (half the US population pays no federal income tax, and the tax code either excludes or favorably treats many income sources).

Over the next several years – the medium term – all countries should implement difficult-to-reverse fiscal consolidation, which would persuade the private sector that a gradual or delayed adjustment, primarily on the spending side of the budget, will occur. Successful consolidation generally relies on spending cuts rather than tax increases – indeed, at a ratio of five or six to one. The US in the 1980’s and 1990’s reduced spending by 5% of GDP and balanced its budget while growing strongly. Canada, in the past two decades, has decreased spending by 8% of GDP and similarly prospered.

In the short run, spending flexibility is appropriate only if medium- and long-term measures are in place. That compromise – between Germany and Southern Europe, and between US Republicans and Democrats – should be economically and politically feasible.

With many citizens now struggling, political leaders face a daunting task: adopt credible medium- and long-term reforms without derailing the economy in the short term. They have little economic – and perhaps even less political – margin for error.

Read more from our "Austerity and its Discontents" Focal Point.